Why does inflation increase with GDP growth?

Reported gross domestic product is adjusted for inflation. The growth of unadjusted GDP means an economy has experienced one of five scenarios:

Produced more at the same prices

Produced the same amount at higher prices

Produced more at higher prices

Produced much more at lower prices

Produced less at much-higher prices

Four of these scenarios either immediately or eventually cause higher prices or inflation.

Scenario 1 implies production is being increased to meet increased demand. Higher production leads to a lower unemployment rate, further fueling demand. Increased wages lead to higher demand as consumers spend more freely. This leads to higher GDP combined with inflation.

Scenario 2 implies there is no increase in demand from consumers, but that prices are higher. Through the early 2000s many producers were faced with increased costs due to the rapidly rising price of oil. Both GDP and inflation increase in this scenario. These increases are due to reduced supply of key commodities and consumer expectations, rather than higher demand.

Scenario 3 implies that there is both increased demand and shortage of supply. Businesses must hire more employees, further increasing demand by increasing wages. Increased demand in the face of decreased supply quickly forces prices up. In this scenario, GDP and inflation both increase at a rate that is unsustainable and is difficult for policymakers to influence or control.

Scenario 4 is unheard of in modern democratic economies for any sustained period and would be an example of a deflationary growth environment.

Scenario 5 is very similar to what the United States experienced in the 1970s and is often referred to as stagflation. GDP rises slowly, below the desired level, yet inflation persists and unemployment remains high due to low production.

Three of these five scenarios include inflation. Scenario 1 eventually leads to inflation, and scenario 4 is unsustainable. From this, it's clear inflation and GDP growth go hand-in-hand. (For related reading, see: The Importance of Inflation and GDP.)

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